US Treasuries Diverging from US Stocks

February 27, 2017

The S&P500 continued to march higher last week. The index moved up almost 0.7% by Friday’s closed. Of course, there was no real enthusiasm on the part of investors because volume fell to one of the lowest levels of the year, so far. Also not confirming the rise in stock prices was the stock market volatility which barely budged; normally the VIX would fall when stock prices rise.

In US macroeconomic news, the results were mixed. On the positive side, existing home sales and consumer sentiment both beat expectations. On the negative side, PMI manufacturing, the Chicago Fed National Activity Index, and new home sales all missed expectations. Initial jobless claims and the FHFA House Price Index both met expectations. So once again, the US economy is not showing any signs of entering any period of robust growth.

If technical analysis suggested that the S&P500 was stretched to the upside the prior week, last week’s additional increase in prices means that the index is even more stretched now. Anyone who puts more or new money to work in this type of market is simply betting that overstretched prices will become even more overstretched in the near future. Clearly, the S&P’s performance over the last several years suggests that this is entirely possible, even in the face of stagnant corporate sales and declining corporate earnings.

Finally, the US Treasury market has begun diverging from the US stock market over the last several weeks. Normally, when stock prices rise, the prices of US Treasuries fall (ie. yields go up).  And this is exactly what’s been going on for most of the period since the S&P took off after the election of Donald Trump. But lately, especially over the last few weeks, the reverse has happened—as stock prices continued to climb, UST yields have started to drop, and by meaningful amounts. In other words, UST prices (and yields) are diverging—negatively—from US stock prices. While this doesn’t mean that stock prices are bound to drop because of this reason alone, it is something that’s important to watch….especially because the size of the US Treasury market is so huge and because it has a good track record of reflecting the views of smarter, more sophisticated institutional investment money.

The Corporate Buyback Story

February 20, 2017

Pushing their luck, stock investors enjoyed another notable jump in the S&P500 last week. The index jumped 1.5% pushing what was already a commonly accepted overvalued market to an even more severe overvalued condition. Confirming that this increase is not some sort of exuberant movement by investors to jump in with both feet is the fact that volume fell. This means that while stocks keep rising, it’s not because there’s a lot of enthusiasm behind the move. S&P volatility crept up; this contradicts the recent price jump. And the price of the US dollar (which tends to rise when equity or risk markets fall), also crept higher to close near multi-year highs. So the strength of the US dollar over the last 24 months also contradicts the jump in US stock prices over the last several months.

US economic reports were mixed last week. Retail sales, the Empire State manufacturing survey, and leading indicators all beat expectations. Industrial production and the housing market index missed expectations. At the same time, consumer prices came in higher (or worse) than expected.

In terms of technical analysis, the S&P500 is almost as stretched as it was in the period leading up to the peak during the dot-com bubble. In no way does this mean that another burst is imminent. but it does suggest that prior major retreats began from technical conditions similar to the one we see today.

In Seeking Alpha, writer Eric Parnell recently analyzed the run-up in US stock prices over the last five years and found a striking correlation between corporate buybacks of their shares and the prices of those stocks. He notes that aggregate corporate earnings have barely budged between 2011 and 2016, but the price PER SHARE has gone up substantially because corporations—through buybacks—have been consistently reducing the number of shares over which this static aggregate corporate earnings figure is spread. And while the earnings per share has gone up, so has the price multiple associated with this EPS. Clearly, this has made the stock market advance look more normal (ie. not so out of whack) because it has artificially increased the earnings per share levels.

How have corporations done this?  Simple—they’ve not only used the bulk of their free cash flows (operating cash flows less net capex) but they’ve borrowed massively. The result is that book equity has been driven down; at the same time, total debt has been driven higher, to replace the reduced equity capital. In fact, the ratio of corporate debt to total capital reached multi-decade highs in the period between 2014 and 2016.

And corporations have gotten away with this massive increase in leverage because the Fed had driven down interest rates to record lows. This kept the total dollar interest expenses manageable. the problem is that while leverage is reaching an “upper bound” of reasonableness, interest rates have jumped substantially since bottoming in June 2016. They rate on the US 10yr Treasury is now about 100 basis points higher than it was back then.

The result is that corporate buybacks have started to slow down massively. Something similar happened in early 2008, well before the stock market collapsed later that year.

The bottom line is that one of the greatest sources of fuel behind the run-up in stock prices over the last five years is now clearly going away, leaving the US stock market at super-stretched prices and more vulnerable than ever to a severe pullback.

As US Stocks Set New Highs, How do Corporate Bonds Look?

February 13, 2017

The S&P500 rose another 0.8% last week in what looked like a resumption of the “Trump trade” that is betting on lower corporate income taxes to boost corporate profits and overall economic growth in the near future. Whether any of Trump’s market-boosting proposals actually get implemented is far from certain, but the US stock market doesn’t care; it is starting to price all this in as a certainty. In the meantime, since sales and overall profits are not yet rising, valuations are getting even more stretched. For the S&P500, price-to-sales and price-to-10 year earnings (Shiller PE) are at levels seen only once or twice over the past 100 years!

In US economic news last week, the results were mostly week. One exception was initial jobless claims, which hit another multi-decade low. The problem with reading too much more positive news into this reading is that history suggests that once claims fall to current levels, they don’t fall much further; in fact, from these super-low levels, they usually begin to climb. The other reports were weak. Gallop’s measure of US consumer spending plunged. Job openings, as measured by t he JOLTS employment survey, fell. Consumer credit missed expectations by a lot. Import prices jumped; this hurts corporate profits. Meanwhile export prices barely budged. Consumer credit also missed.

Since almost all broad and well-established measures of US stock market valuation clearly show that prices are on the high side of average, an investor looking for value could naturally ask about the other major corporate security available to buy—corporate bonds. Specifically, how do the prices of investment grade and high yield bonds look?

One important measure to assess is the yield spread between corporate bonds and comparable (in terms of maturity) US Treasuries. When the spread is large (ie. the corporate bonds pay a lot more than the comparable Treasuries) then the corporate bonds are priced lower….in other words, more attractively. When the spread is small, then the corporate bonds are priced high.

Today, the spread between Treasuries and high yield corporate bonds is as low as it’s been since before the Great Recession began. In other words, high yield bonds are not cheap; arguably, they are expensive and offer little value.

For investment grade corporate bonds (say BBB rated paper), the same is true—spreads are lower than they’ve been since late 2014 and the period before the Great Recession began (2004-2007). So investment grade corporate bonds are also not cheap; arguably, they’re expensive.

Once again, this makes life difficult for anyone trying to build a value-oriented portfolio. Not only are most US stocks very expensive, but so are most US corporate bonds. And given that stocks and bonds make up the bulk of any large investment portfolio—at least they ought to—this means that when the next market correction hits, even a well diversified portfolio will get hurt more than it might otherwise, since both corporate bonds and equities will most likely retreat in valuation.


Gold and Silver Poised to Jump?

February 6, 2017

The S&P500 ended last week essentially unchanged…..actually rising but by an ever so tiny 0.1%. Volume was light, which is unsurprising in a market that showed no net direction during this period. And volatility also didn’t move much, but more so because it was already hugging multi-year lows; investors remain super complacent.

In US macro news, the week got off to a poor start. Personal income missed expectations; personal spending only met expectations. The Case-Shiller home price index (20 city, not seasonally adjusted) missed expectations—while home prices rose, they rose far less than expected. The Chicago PMI result was a disaster, coming in far below the consensus estimate. Consumer confidence also missed. Construction spending missed, and so did ISM services. On the positive side of the ledger, ISM manufacturing beat expectations. Initial jobless claims were better than expected. And factory orders also exceeded expectations. The big number of the week, payrolls, was a mixed bag. On the one hand, the headline jobs number was stronger than expected, but on the other hand, headline unemployment ticked higher and average hourly earnings missed badly.

Given that the S&P500 barely budged last week, the technical picture also didn’t change much—the S&P remains extremely stretched to the upside and looks very vulnerable to at least some sort of sell-off….at the very least, a retreat back down to the 50 day moving average would be a simple target. Instead, it continues to hug the upper Bollinger Band, suggesting it’s somewhat above fair value.

Technical analysis, meanwhile, is painting a bullish picture for precious metals. Both gold and silver have traced out a long-term (weekly) inverted head-and-shoulders formation on their respective charts. One key part in this formation was the failure of both gold and silver to make a new low in late 2016; the prior major low at the end of 2015 was deeper. The second and remaining part of this formation involves the neckline and whether or not it will be broken to the upside. For gold, this is around $1,400 which was last seen in mid-2016. If gold rises, and stays, above this level, then there could be a lot more upside ahead for it. So precious metals will be interesting to watch over the upcoming weeks and months.